Curious Cat Investing Dictionary: Leverage

Leverage - the ability to control assets without putting up the entire cost. This increases the magnitude of gains and losses for the same initial investment. Examples of leverage: mortgages, futures contracts and buying stock on margin. Leverage provides the ability to enhance returns and carries the risk of enhanced losses.

Excessive leverage has often lead to financial crises including. In the 1920's leverage of 10 to 1 was allowed for stock purchases. To buy $10,000 worth of stock one only needed $1,00. If the stock increased 10% the value increased to $11,000 and since you only invested $1,000 your return was 100%. If the price fell 10% your entire investment was gone. The margin requirement was increased to 50% for years but in the 1990's the margin requirements were greatly relaxed but on a varying scale depending on the stock (normally stocks under $5 a share could not be bought on margin).

When putting 20% down on a house the leverage is 5 to 1. When putting 5% down the leverage is 20 to 1. Obviously the return and risk are both greatly increased by increased leverage.

Businesses can increase their leverage by borrowing huge sums. Often buyouts of companies involve greatly increasing the use of borrowed money which saddle companies with large interest payments. This has the same effect of increasing risk as small shifts in the performance of the company result in an inability to cover the massive interest payments introduced in order to increase the potential returns.